A company with a superior ESG score is rewarded by the markets.
The coronavirus pandemic has provided a watershed moment for wealth managers to accept and recognize the importance of sustainable and socially responsible investment practices. This could accelerate the spread of ESG (environmental, social and corporate governance) funds. The category of funds applies ESG factors to the investment process. In a pre-Covid world, the investor community was highly fixated on the one or two-year forward projected earnings for stock selection purposes, while the sustainable investment theory was seen just as a fad or an evolving theory. However, the outbreak of COVID-19 has disrupted this view. Global commerce was brought to a screeching halt for a few months, challenging investors’ confidence in the efficacy of excel sheet-driven projections. Investors have now started to accord a sizable weight for long-term sustainability of a business while making investment decisions. The relevance of sustainability-based investment, in the current environment, perfectly corroborates with the famous quote of Warren Buffet’s: ‘only when the tide goes out do you discover who’s been swimming naked.’ A staunch ESG investor believes that a company cannot always maximize long-term profits; it should instead emphasize on delivering excellent products, which create profit as a side effect.
Stock Picking: ESG versus conventional methods
A traditional fund manager selects a stock based on just the usual financial measures such as scalability of a company’s products, balance-sheet strength or free cash generation capability. In addition to financial parameters, the ESG fund manager will also thoroughly scrutinize the company on factors such as the degree of the water recycled during manufacturing; whether it’s a zero-waste company or not, measures taken to reduce its carbon footprint, or working conditions of its employees and suppliers, and the governance practiced by the company. By incorporating the ESG practice, a fund manager minimizes the risk of hefty penalties, if any, emerging from the pollution created by the company. A good work ethic ensures that the company is protected from any kind of strikes or boycott, and a strict governance practice keeps it away from any kind of regulatory hurdles.
ESG Score: The way ahead for corporates
Corporates too are now realizing the importance of improving their ESG scores due to increasing pressure from wealth managers. A company with a superior ESG score is also rewarded by the markets, as it accords a premium price-earnings multiple when compared to its counterparts. Blackrock, the world’s largest asset manager, issued a letter to companies saying it would be now increasingly disposed to vote against boards that move very slowly on sustainability. Likewise, Chris Hohn, a head of London-based hedge fund, speaks about voting against directors of companies that fail to reveal their carbon emissions.
These non-financial parameters are formed into a composite ‘ESG score.’ An ESG fund manager assigns active weights to stocks based on their ESG scores. So far, there are no strict norms for developing an ESG score and every index manager has a different way of calculating it. However, large wealth managers are gradually setting up their own internal teams to arrive at an ESG score.
Gaining Prominence Globally
Sustainable and socially responsible investment, which has been largely confined to university academic papers, is moving into the mainstream and gaining heft, thanks to investors looking for financial products that have sustainability objectives. As a result, flows into sustainable funds rose $154 billion in 2019, the highest in the decade and the total amount is equivalent to the cumulative flow of the previous four years. The number ESG funds globally rose to 3308 in the last ten years. More than $3 trillion of institutional assets—which is more than India’s market capitalization—is tracking ESG scores for making investment decisions.
ESG investment is at an emerging stage in India, but it is gradually gaining traction. The asset under management of the three ESG funds in India was Rs 4,500 crores at the end of August 2020, and it accounted for 0.6 per cent of the total equity AUM. Experts believe that high net-worth investors are exhibiting a growing appetite for ESG investments, as they are now increasingly aware of the worth of a sustainable investing practice, particularly after the pandemic.
The returns of the benchmark index have been encouraging too, according to the index factsheet on the NSE at the end of August 2020. The Nifty 100 ESG index has outperformed the Nifty 50 in the last one-year and five-year periods by 4.39 percentage points and 1.39 percentage points, respectively. The Nifty 100 ESG Total Return Index has grown at an annual rate of 9.48 per cent since 2011, while the Nifty 50 TRI recorded a growth of 7.8 per cent in the same period.
Further, the performance of an ESG friendly portfolio has been resilient during downturns. So, the Nifty 100 ESG index recovered faster from the March 2020 lows than the Nifty 50.
ESG funds could attract investors’ attention and also generate interest from pension funds, large institutions and millennials.